Pages

Tuesday, November 23, 2010

Will the market virus kill the global economy?

A successful virus does not kill its host, it just makes it ill in the hope that it stupidly staggers off to work, coughing over other people so that the virus can parasitise them too.

The Bond Markets are like a virus. They profit off high interest rates on loans given to dodgy countries, but at the risk that those countries' economies will collapse, which would mean that the bond holders would lose their money.

That is what is happening in the world economy. The markets are circling the weakest economies, pumping up the cost of their debt, which makes them weaker still. Desperate, the countries cut their spending, which puts more out of work, lowering the tax take, weakening the economy yet further. Confidence fails, and confidence is the life force of economics.

The vast majority of countries are in debt of various kinds. Take a look at this list of counties' external debt. External debt includes public and private borrowing. Play with it, clicking the various headings to list countries by absolute debt, debt as a ratio of GDP, and see how people are doing. Luxembourg is worst, with external debt at 3854% of GDP. Then Ireland, at 1004% of GDP. We're at 416%. Mighty Germany is a mere 155%.

That's external debt. Now take a look at countries listed by public debt here. Public debt is Government borrowing, leaving out private borrowing. We are not so bad on this one, 22nd from the bottom, at 68% of GDP, as opposed to Germany who is 19th from bottom, with 72% of GDP.

The point is that nearly everyone is in debt, which ought to be no surprise, because money is created through debt. If you need money, you go to the bank, and the bank manager glances at you to make sure your shoes are shiny and your tie is straight, then creates your money for you. He writes the figure in your account, which is his liability, and an equal figure in his account, which is his asset. The figures exactly match. If you perform properly, you pay back first the interest, and then the capital sum. At the end of the term, asset and liability cancel each other out, and the bank is better off by the amount of interest you paid over the years. If you do not perform properly, and default on your loan, the bank manager is fucked. And this is what has happened.

I suspect that is what Osborne is doing with this loan for Ireland. Everyone is rightly puzzled about where the £7, no £8, no £10 billion that we are lending to Ireland is coming from, given that we have no money to pay the police &c. Since it is a loan, it comes from exactly the same place that a bank manager creates a loan - out of thin air, or to be more exact, out of the UK's confidence that Ireland will pay us back in time, with 5% interest.

It is all bloody mystical, or religious even. You believe in Father Christmas, and Father Christmas it is who fills your stocking. You believe the financial system is doing good, then debt it no problem, it's just LEVERAGE, that's OK, it's the way the system works. But if you lose faith in the system, then debt is DEBT, a slavering monster that will eat you up. As you believe, so it happens.

Imagine you are on a desert island, alone. You need to provide water, food, shelter, warmth, and keep your shit away from the water source. That is your economy. It is all founded on ecology - your relationship with the environment.

The fact is that modern economics has lost sight of its ecological foundations, and has fallen into a very dodgy bramble patch of debt-created money.

OK, the present round of bailouts for Greece, Ireland &c may resolve the issue, and it may all settle down again. Wise, firm government action may calm the markets, and the world economy will take up business as usual, growing merrily away. The present loans to Greece and Ireland, which after all only put off the day of reckoning, may get repaid in 2013 or 2015 or whenever. Governments may wake up to what work really is, stop attacking the people, and start sewing up the tax avoidance holes that are haemorrhaging public wealth into the tax havens. Governments may wake up to the reality of the Green New Deal, and use the Green Wage Subsidy to get people into work while at the same time making a transition to a green economy.

We live in hope.

Except the economy cannot keep growing merrily away. That is impossible. Specifically, we face up to Peak Oil. in the next decade or so. Oil is the lifeblood of the world economy. I cannot see the present financial system surviving a collision with Peak Oil.

The only way to mitigate peak oil is through energy conservation and a massive investment in renewable energy and an HVDC super-grid. This is achievable physically. The problem is that politicians have not got their heads round it.

Whatever happens, we have to move towards a sustainable economy. It is do-able, at a pinch, if all factors are addressed. We could make a smooth transition, using what we have now in the way of a financial system. On the other hand, the politicians, corporations and financiers in power are so knuckle-headed, we may have to go through a period of financial collapse and build a Green economy out of the ruins of the old, irrational, debt based "economy". In short, the virus of the money markets may kill the irrational economic system that they have parasitised so effectively.

PS: The debate over how money is created is endlessly confused. I like to take it in easy steps to try to bypass the confusion. Fist step is to show that the money supply is indeed increasing, and here is the evidence:

OK? Money supply is increasing. So someone or something must be creating it. The vast majority (97% in the case of the UK) is created by the banking system - the only bit Govrenments get to create is the notes and coins.

I will stop at this stage of the argument in order to mreaake sure we are all aboard so far.

16 comments:

"If you need money, you go to the bank, and the bank manager glances at you to make sure your shoes are shiny and your tie is straight, then creates your money for you. He writes the figure in your account, which is his liability, and an equal figure in his account, which is his asset. The figures exactly match. If you perform properly, you pay back first the interest, and then the capital sum. At the end of the term, asset and liability cancel each other out, and the bank is better off by the amount of interest you paid over the years."

My comment:

The bank isn’t better off by the amount of interest you’ve paid, because most of it is passed back to the depositor of the money that was lent. The money is lent from depositor to borrower, and the interest is paid back in the other direction. The bank is just the go-between, and collects a fee for the service. Quite likely the fee is excessive but that’s another story.

You’ve got a flair for words but I wish you would be more careful about your logic.

Monetary reformers like yourself have excitedly been quoting a proposal mentioned by Mervyn King “to divorce the payment system from risky lending activity – that is to prevent fractional reserve banking”. (25 October 2010, www.bankofengland.co.uk/publications/speeches/2010/speech455.pdf).

But this was just one of his examples of “radical reforms” that have been proposed by other people “for reducing the riskiness of our financial system” that “offer the hope of avoiding the seemingly inevitable drift to ever more complex and costly regulation.”

I am more interested in his comments that:

“. . . the regulatory framework needs to contain elements that are robust with respect to changes in the appropriate risk weights, and that is why the Bank of England advocated a simple leverage ratio as a key backstop to capital requirements.”

“Regulators will never be able to keep up with the pace and scale of financial innovation. Nor should we want to restrict innovation. But it should be undertaken by investors using their own money not by intermediaries who also provide crucial services to the economy, allowing them to reap an implicit public subsidy“

“if banks undertake risky activities then it is highly dangerous to allow such “gambling” to take place on the same balance sheet as is used to support the payments system, and other crucial parts of the financial infrastructure.”

“The broad answer to the problem is likely to be remarkably simple. Banks should be financed much more heavily by equity rather than short-term debt.”

This is odd. I get an email reporting a comment on this post, but it isn't up here. so I paste it:-

A. Marshall has left a new comment on your post "Will the market virus kill the global economy?":

You wrote:

"If you need money, you go to the bank, and the bank manager glances at you to make sure your shoes are shiny and your tie is straight, then creates your money for you. He writes the figure in your account, which is his liability, and an equal figure in his account, which is his asset. The figures exactly match. If you perform properly, you pay back first the interest, and then the capital sum. At the end of the term, asset and liability cancel each other out, and the bank is better off by the amount of interest you paid over the years."

My comment:

The bank isn’t better off by the amount of interest you’ve paid, because most of it is passed back to the depositor of the money that was lent. The money is lent from depositor to borrower, and the interest is paid back in the other direction. The bank is just the go-between, and collects a fee for the service. Quite likely the fee is excessive but that’s another story.

You’ve got a flair for words but I wish you would be more careful about your logic.

Monetary reformers like yourself have excitedly been quoting a proposal mentioned by Mervyn King “to divorce the payment system from risky lending activity – that is to prevent fractional reserve banking”. (25 October 2010,www.bankofengland.co.uk/publications/speeches/2010/speech455.pdf).

But this was just one of his examples of “radical reforms” that have been proposed by other people “for reducing the riskiness of our financial system” that “offer the hope of avoiding the seemingly inevitable drift to ever more complex and costly regulation.”

I am more interested in his comments that:

“. . . the regulatory framework needs to contain elements that are robust with respect to changes in the appropriate risk weights, and that is why the Bank of England advocated a simple leverage ratio as a key backstop to capital requirements.”

“Regulators will never be able to keep up with the pace and scale of financial innovation. Nor should we want to restrict innovation. But it should be undertaken by investors using their own money not by intermediaries who also provide crucial services to the economy, allowing them to reap an implicit public subsidy“

“if banks undertake risky activities then it is highly dangerous to allow such “gambling” to take place on the same balance sheet as is used to support the payments system, and other crucial parts of the financial infrastructure.”

“The broad answer to the problem is likely to be remarkably simple. Banks should be financed much more heavily by equity rather than short-term debt.”

I'm quite happy with your explanation: "the bank manager . . . creates your money for you. He writes the figure in your account, which is his liability, and an equal figure in his account, which is his asset. . . At the end of the term, asset and liability cancel each other out . . ."

There is an explanation of how transactions like this add up, headed "The multiplier effect in the creation of money", on my website, at ammpol.wordpress.com/ammiim.

No. I am not in denial about interest on deposits. I simply did not mention it.

We agree that rates paid on bank loans are less than rates paid on bank loans, which the bank justifies as its fees to sustain the institution. (It would be interesting to see the figures on this. What are the ratios of deposits and loans?).

I have now included your point on the pathway we are trying to construct, which now runs:

1 Money is being created.2 Banks create money by lending at interest.3 Although banks also borrow from depositors at interest, the interest rates are always lower for savers than for borrowers. 4 To pay back the interest means that the lender has to make a profit on the market.

>We agree that rates paid on bank loans are less than rates paid on bank loans

I assume you mean We agree that rates paid on bank deposits are less than rates paid on bank loans

> What are the ratios of deposits and loans?

. . . before the crash, giant banks kept considerably less than one percent of all the money they borrowed in cash. . . only a fraction of the cash you've deposited is retained by your bank. . . in fractional reserve banking . . . (Robert Peston, “Britain’s Banks: Too Big To Save?”, BBC2, 18 January 2011.)

> To pay back the interest means that the lender has to make a profit on the market.

I assume you mean borrower not lender. To pay interest the borrower may use profits gained from the loan or money gained elsewhere.

Apologies for terminological errors. I really must concentrate harder on proofreading.

Yes, the actual money held by banks is only a fraction of the money they lend out. So the money they pay out in interest on deposits is much less than the money they take in as interest on their loans.

In an ideal world, we would be able to quantify the relationship between the amount of interests that banks pay out to depositors, and the amount of interest that borrowers pay in to banks.

The figures are there, but neither of us have the time, I suspect, to dig them up.

However, the difference must surely be the amount by which the total supply of money is increasing, because there is no other source of money creation in the system, is there?

So:

1 Money is being created.2 Banks create money by lending at interest.3 Although banks also borrow from depositors at interest, the interest rates are always lower for savers than for borrowers, and the amounts retained on deposits are in the order of one percent of the amounts lent out.4 To pay back the interest means that the lender has to make a profit on the market.

Next, I wish to show that this system is a driver for economic growth. I will devote a blog post to that.

> the relationship between the amount of interests that banks pay out to depositors, and the amount of interest that borrowers pay in to banks . . . the difference must surely be the amount by which the total supply of money is increasing, because there is no other source of money creation in the system, is there?

Yes there is. The amount of money circulating is decided by the amount of economic activity. As agreed in step 2, banks create money by lending. Until a loan is paid back, the total money supply has been increased by the debt. The debt is the new money, the interest isn’t. The interest is paid using already existing money.

Also I don’t agree, and didn’t agree, with your step 4. The lender can pay the interest out of money earned elsewhere. The interest paid on mortgages is an example. Usually this is paid out of money earned as wages, not from profit on the mortgage.

As I expected, this step-by-step analysis hasn’t resulted in any change of mind by either of us. Its not the first time we've discussed it.

AM: The amount of money circulating is decided by the amount of economic activity.RL: There are 2 factors relating money to economic activity.

Economic activity can increase using the same amount of money if there is a speeding up the velocity of money in circulation. Gesell. As happened in Worgl.

The local authority issued money with a built in property of velocity in circulation, and in the midst of the Great Depression, Worgl thrived.

A manufacturer in Worgl who wanted to update his machinery might have gone to the banks for the money, as above.

Or

In theory, if the town saw an opportunity to reduce the energy costs of the citizens, by, say, insulating the houses, if the business plan was good, the authority could reasonably have furnished the money, as a low/zero interest loan, or even as a grant. Depending on the figures for savings from the scheme, some of which could be recouped as tax.

In short, they could have done a Green New Deal, which is what the Green Party rightly leads on.

AM: Until a loan is paid back, the total money supply has been increased by the debt. The debt is the new money, the interest isn’t. The interest is paid using already existing money.

RL: Sure, the interest is paid back to the bank from money drawn from the general circulation. But going back to our example, the competitors also are driven to take out loans. Or of course, they could go down the tubes, and the value of their business, and the workers' livelihoods, could be destroyed, which would take money out of circulation.

So the interest is partly paid for by newly created money taken out by the competitor.

The key point is that if economic progress is mediated only through bank loans, there is an burden of debt that drives companies to increase productivity to pay it off.

Therefore the monopoly of the banks in the matter of money creation drives economic growth. Since non-green economic growth is unsustainable and ecologically illiterate, the monopoly of the banks to create money must be ended. Period.

I must add another vitally important point. The monopoly must certainly not shift to the State. The power to issue new money should be shared more or less 50-50 between the "National Bank" - by whatever name - and the private banks. This could be determined by setting the Fractional Reserve at 50, I believe.

The beauty of this is that it gives politicians a knob to twiddle. They can vary it, so the state did more and the privates did less, and vice versa.

I know I should express this all much more precisely, but I have to go and make dinner right now.